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Moral hazard, bank runs and contagion

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  • Chatterji, S.
  • Ghosal, S.

Abstract

We study banking with ex ante moral hazard. Resolving the misalignment of the incentives between banks and depositors requires early liquidation with positive probability: e¢cient risk-sharing between depositors is no longer implementable. In a closed region with a single bank, we show that (i) with costless and perfect monitoring, contracts with bank runs o¤ the equilibrium path of play improve on contracts with transfers, (ii) when the bank’s actions are non-contractible, equilibrium bank runs driven by incentives are linked to liquidity provision by banks. With multiple regions linked via an interbank market, with local moral hazard, we show that implementing second-best allocations requires both ex-ante trade in inter-bank markets and contagion after realization of liquidity shocks.

Suggested Citation

  • Chatterji, S. & Ghosal, S., 2008. "Moral hazard, bank runs and contagion," Economic Research Papers 269785, University of Warwick - Department of Economics.
  • Handle: RePEc:ags:uwarer:269785
    DOI: 10.22004/ag.econ.269785
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